Bond indices incorporating prices from several participants, such as iBoxx and Trac-x, gained sizeable market share in a bond market that was crying out for greater independence and diversity in 2003. However, their position is at risk.

âThis town is big enough for two index familiesâ

Niall Cameron, ABN Amro

Fixed-income investors who less than a year ago jumped at the chance to measure their portfolio performance against third-party indices have grown wary, in the wake of several corporate blow-ups that threatened their holdings. The danger is that owning a broad market index is more likely to expose investors to corporate bond defaults.

Bankers who support bond indices, which enjoyed a huge growth in popularity last year, say they have already been proven to be a valuable tool for investing in and trading securities, and hedging the associated risk.

The default and subsequent fraud crisis engulfing Parmalat, the Italian foods group, is a good example of how market events can test the structural viability of credit indices. Parmalat debt was included in the portfolio of bonds that incorporated the iBoxx Diversified index as recently as last September.

However, the portfolio was reweighted a matter of days before the Italian company went bankrupt in December, shielding investors from potential fall-out and demonstrating the worth of such indices.

Niall Cameron, global head of credit markets at ABN Amro, said: “When such an event happens, it is a test of the product. When there are corporate blow-ups, that enhances the appeal of adopting an index-based approach for investors. Not only does such an approach meet investors’ yield needs, it diversifies the risks and allows investors to avoid putting all their eggs in one basket.”

For investors without extensive credit research teams the existence of diversified indices is a godsend. They can get diversified credit exposure without having to invest in an expensive research and portfolio management team. Of course, they effectively outsource portfolio management to the index provider and there is no guarantee that iBoxx will manage to avoid the next Parmalat. Nevertheless, as long as index composition and reweighting is up to scratch, it offers a cost-effective solution to credit fund management.

After iBoxx’s launch last year, turf warfare erupted in the bond index world as rival investment banks fought fiercely for market share. JP Morgan, which offered its own in-house rival index product called Jeci, first attacked the new iBoxx product and then banded together with Morgan Stanley to create the Trac-x family of indices.

After an initial period of conflict, the two dominant factions in the European bond index sector have set aside their mudslinging and used the existence of competition as a spur to develop a broader range of products.

The rivalry between the iBoxx and Trac-x products, both of which enjoyed a highly successful year in 2003 and are vying for a leading position in the market this year, has given rise to speculation that they may merge, although bankers connected to the products are keen to play down the idea.

Cameron said: “This town is big enough for two index families. There is a lot of debate about whether to opt for a single, open architecture product that offers better liquidity and transparency, but that is not necessarily the best option. Having a rival product helps to drive innovation and adds to price tension because traders are under pressure to compete.”

Cameron conceded that it could be beneficial for the two indices to merge at some point, although he did not believe that will happen immediately. Instead, he said the focus in 2004 will be on continuing to forge ahead with new products. Market participants expect the range of credit-related instruments on offer to expand to include the futures market this year.

Bankers say investor appetite for bond indices has grown, rather than diminished, in the wake of corporate bond blow-ups such as Parmalat. One banker said: “Yields have risen in the early part of 2004 and these types of products have come into their own as risk-hedging instruments.” Both index providers have also launched standardised credit default swaps on tranches of their indices.

However, for investors out to hedge specific risks, individual credit default swaps, which enable investors and banks to protect themselves against the risk of an issuer defaulting on its bonds, are the more obvious choice.

As the bond markets have become more like their equity counterparts, prone to move on expectation rather than actual events, the default swap market has become a lead indicator and in some ways a more accentuated sign of trends in the mainstream bond market.